Monopoly Monopolistic Competition-Managerial Economics-Lecture Notes, Study notes of Managerial Economics

Download Monopoly Monopolistic Competition-Managerial Economics-Lecture Notes and more Study notes Managerial Economics in PDF only on Docsity! Lesson 28 MONOPOLY / MONOPOLISTIC COMPETITION SOCIAL COST OF MONOPOLY Patents One of the major sources of monopoly is that the firm might own a patent. The ownership of a patent or copyright that precludes other firms from using a particular production process or producing the same product. Intellectual Property (IP) is critical for competitive economy in the back drop of ongoing globalization. Sustainable economic growth now depends largely on Hi- tech R&D base and efficient knowledge input. The new concept of IP based nation is gaining ground because it is Intellectual Property which enables technology creation and technology transfer by providing the necessary enabling environment. For these considerations Intellectual Property was mainstreamed in Pakistan in 2005. A patent for an invention is grant of exclusive rights to make, use and sell the invention for a limited period of 20 years. The patent grant excludes others from making, using, or selling the invention. Patent protection does not start until the actual grant of a patent. Patent is granted when the application for it is submitted to IPO (Intellectual Property Rights Organization of Pakistan). Figure 1 In case of competitive markets, we have observed that price and quantity that creates balance between supply and demand also maximize the total social welfare derived from such activity. We have measured the social welfare of the society by consumers’ surplus and producers’ surplus. For example in case of the markets for drugs when a patent gives a firm a monopoly over the sale of a drug, the firm charges the monopoly price, (point T in Figure 1, price during patent life) which is well above the marginal cost of making the drug. When the patent on a drug runs out, (Point N, price after patent expires) new firms enter the market, making it more competitive. As a result, price falls from the monopoly price to marginal cost. SOCIAL BENEFITS OF MONOPOLY Economies of Scale  In natural monopoly, LRAC declines continuously and one firm is most efficient.  Some real-world monopolies are government-created or government-maintained Dilemma of Natural Monopoly docsity.com  Monopoly has the potential for efficiency.  Unregulated monopoly can lead to economic profits and underproduction. Natural monopoly presents something of a dilemma. On the one hand, economic efficiency could be enhanced by restricting the number of producers to a single firm. On the other hand, monopolies have an incentive to under produce and can generate unwarranted economic profits. A very large scale of operation is often required to produce most products efficiently, and this is possible when only a few firms are operating. For example, economies of scale operate over such a large range of outputs that steel, aluminum, automobiles, mainframe computers, aircraft, and many other products and services can be produced efficiently only by very large firms, so that a handful of such firms can meet the entire market demand for the product or service. Perfect competition under such conditions would either be impossible or lead to extremely high production costs. One could only imagine how high the cost per unit would be if automobiles were produced by 100 or more firms instead of by three or four very large firms. Figure 2 Figure 2 shows that without regulation, natural monopolies would charge quite high prices (P’) and produce too little output (OQ). MONOPOLISTIC COMPETITION A market structure that lies between the extreme of monopoly and perfect competition is monopolistic competition. The partly competitive, partly monopolistic market structure faced by the firms in the clothing, food, hotel, retailing, and consumer products industries is called monopolistic competition. Given the lack of perfect substitutes, monopolistically competitive firms have some discretion in setting prices—they are not price takers. However, given fierce competition from imitators offering close but not identical substitutes, such firms enjoy only a normal rate of return on investment in long-run equilibrium. Monopolistic competition is similar to perfect competition in that there is large number of sellers this two market structure model. The major difference between these two market structure models is that consumers perceive important differences among the products offered by monopolistically competitive firms, whereas the output of perfectly competitive firms is docsity.com competitors emerge to offer close but imperfect substitutes, the market share and profits of the initial innovating firm diminish. Firm demand and marginal revenue curves shift to the left as, for example, from D1 to D2 and from MR1 to MR2 in Figure 4. Optimal long-run output occurs at Q2, the point where MR2 = MC. Because the optimal price P2 equals ATC2, where cost includes a normal profit just sufficient to maintain capital investment, economic profits are zero. The price/output combination (P2Q2) describes a monopolistically competitive market equilibrium characterized by a high degree of product differentiation. If new entrants offered perfect rather than close substitutes, each firm’s long-run demand curve would become more nearly horizontal, and the perfectly competitive equilibrium, D3 with P3 and Q3, would be approached. Like the (P2Q2) high-differentiation equilibrium, the (P3Q3) no-differentiation equilibrium is something of an extreme case. In most instances, competitor entry reduces but does not eliminate product differentiation. An intermediate price/output solution, one between (P2Q2) and (P3Q3), is often achieved in long-run equilibrium. Indeed, it is the retention of at least some degree of product differentiation that distinguishes the monopolistically competitive equilibrium from that achieved in perfectly competitive markets. Figure 4 A firm will never operate at the minimum point on its average cost curve in monopolistically competitive equilibrium. Each firm’s demand curve is downward sloping and is tangent to the ATC curve at some point above minimum ATC. However, this does not mean that a monopolistically competitive industry is inefficient. The very existence of a downward-sloping demand curve implies that consumers value an individual firm’s products more highly than they do products of other producers. The higher prices and costs of monopolistically competitive industries, as opposed to perfectly competitive industries, reflect the economic cost of product variety. If consumers are willing to bear such costs, then such costs must not be excessive. The success of branded products in the face of generic competition, for example, is powerful evidence of consumer preferences for product variety. MONOPOLISTIC COMPETITION PROCESS Short-run Monopoly Equilibrium  Monopolistically competitive firms take full advantage of short-run monopoly.  In short run, MR = MC, P > AC, and  > 0. docsity.com Long-run High-price/Low-output Equilibrium  With differentiated products, MR = MC and P = AR = AC at a point above minimum LRAC.  No excess profits exist, so  = 0. Long-run Low-price/High-output Equilibrium  With homogenous products, MR = MC and P=AC at minimum LRAC.  No excess profits exist, so  = 0. This is competitive market equilibrium. SHORT-RUN MONOPOLY EQUILIBRIUM (EXAMPLE) Given TR = 20,000Q – 15.6Q2 TC = 400,000 + 4640Q + 10Q2 MR = 20,000 – 31.2Q MC = 4640 + 20Q P = AR = 20,000 – 15.6Q P = 20,000 – 15.6(300) P = $15,320  = TR – TC = 20,000Q – 15.6(300)2 - 400,000 – 4640(300)Q - 10(300)2 = - 361,250 + 45Q - 0.00045Q2  = $1,904,000 or = $1.9 million MR = MC 20,000 – 31.2Q = 4640 + 20Q 51.2Q = 15,360 Q = 300 units P = AR = 20,000 – 15.6Q P = 20,000 – 15.6(300) P = $15,320  = TR – TC = 20,000Q – 15.6(300)2 - 400,000 – 4640(300)Q - 10(300)2 = - 361,250 + 45Q - 0.00045Q2  = $1,904,000 or = $1.9 million Therefore, the financial planning committee should recommend a $15,320 price and 300-unit output level to maximize short run profits. LONG-RUN HIGH-PRICE/LOW-OUTPUT EQUILIBRIUM AC = TC/Q = 400,000/Q + 4640Q/Q + 10Q2 /Q = 400,000 Q-1+ 4640 + 10Q, the slope of this AC curve is given by the expression: AC = -400,000 Q-2+ 10 The slope of the new demand curve is given by: = - 15.6 (same as the original D-curve) Slope of AC curve = Slope of Demand curve -400,000 Q-2+ 10 = - 15.6 Q = 125 Units = 400,000/125 + 4640 + 10(125) = $9,090 docsity.com  = P * Q – TC = 9,090(125) – 400,000 – 4,640(125) – 10(125)2 = $0 LONG-RUN LOW-PRICE/HIGH-OUTPUT EQUILIBRIUM The low-price/high-output (perfectly competitive) equilibrium combination occurs at the point where P = MR = MC = AC. This reflects that the firm’s demand curve is perfectly horizontal, and average costs are minimized. To find the output level of minimum average costs. Set MC = AC and solve for Q: MC = AC 1,640 + 20Q = 400,000 Q-1+ 4640 + 10Q Q2 = 40,000 Q = 40,000 200 Units P = AC 400,000/200 + 4,640 + 10(200) = $8,640 Under this low-price equilibrium scenario, ABC monopoly price falls in the long run from an original $15,320 to $8,640, and output falls from the monopoly level of 300 units to the competitive equilibrium level of 200 units per month. The company would earn only a risk adjusted normal rate of return, and economic profits would equal zero.  = P * Q – TC = 8,640(200) – 400,000 – 4,640(200) – 10(200)2 = $0 Following the onset of competition, the firm XYZ’s will reduce its output from 300 units/month to a level between Q = 125 and Q = 200 units/month. S-Run profit-Max price = $15,320 will fall between P = $ 9,090 (High-price/Low-output Equilibrium) And P = $8,640 (Low-price/High-output Equilibrium) docsity.com